Knowledge that Transforms

Recent asset pricing models of limits to arbitrage emphasize the role of funding conditions faced by financial intermediaries. In the US, the repo market is the key funding market. Then, the premium of on-the-run U.S. Treasury bonds should share a common component with risk premia in other markets. This observation leads to the following identification strategy. We measure the value of funding liquidity from the cross-section of on-the-run premia by adding a liquidity factor to an arbitrage-free term structure model. As predicted, we find that funding liquidity explains the cross-section of risk premia. An increase in the value of liquidity predicts lower risk premia for on-the-run and off-the-run bonds but higher risk premia on LIBOR loans, swap contracts and corporate bonds. Moreover, the impact is large and pervasive through crisis and normal times. We check the interpretation of the liquidity factor. It varies with transaction costs, S&P500 valuation ratios and aggregate uncertainty. More importantly, the liquidity factor varies with narrow measures of monetary aggregates and measures of bank reserves. Overall, the results suggest that different securities serve, in part, and to varying degrees, to fulfill investors' uncertain future needs for cash depending on the ability of intermediaries to provide immediacy.

Nonlinearity is an important consideration in many problems of finance and economics, such as pricing securities and solving equilibrium models. This article provides analytical treatment of a general class of nonlinear transforms for processes with tractable conditional characteristic functions. We extend existing results on characteristic function-based transforms to a substantially wider class of nonlinear functions while maintaining low dimensionality by avoiding the need to compute the density function. We illustrate the applications of the generalized transform in pricing defaultable bonds with stochastic recovery. We also use the method to analytically solve a class of general equilibrium models with multiple goods and apply this model to study the effects of time-varying labor income risk on the equity premium.

This paper proposes and tests an investment-flow based explanation for three empirical findings on return predictability -the persistence of mutual fund performance, the "smart money" effect, and stock price momentum. Since mutual fund managers generally scale up or down their existing positions in response to investment flows, and the portfolios of funds receiving capital generally differ from those that lose capital, investment flows to mutual funds can cause significant demand shocks in individual stocks. Moreover, given that mutual fund flows are largely predictable from past fund performance and past flows, this paper further establishes that flow-induced price pressure is predictable. Finally, this paper shows that such flow-based return predictability can fully account for mutual fund performance persistence and the "smart money" effect, and can partially explain stock price momentum.

Although the threat of rare economic disasters can have large effect on asset prices, difficulty in inference regarding both their likelihood and severity provides the potential for disagreements among investors. Such disagreements lead investors to insure each other against the types of disasters each one fears the most. Due to the highly nonlinear relationship between consumption losses in a disaster and the risk premium, a small amount of risk sharing can significantly attenuate the effect that disaster risk has on the equity premium. We characterize the sensitivity of risk premium to wealth distribution analytically. Our model shows that time variation in the wealth distribution and the amount of disagreement across agents can both lead to significant variation in disaster risk premium. It also highlights the conditions under which disaster risk premium will be large, namely when disagreement across agents is small or when the wealth distribution is highly concentrated in agents fearful of disasters. Finally, the model predicts an inverse U-shaped relationship between the equity premium and the size of the disaster insurance market.

We employ a novel dataset on almost 30,000 trade credit contracts to describe the broad characteristics of the parties that contract together and the key contractual terms of these contracts. Whereas prior work has typically used information on only one side of the buyer-seller transaction, this paper utilizes information on both, allowing for the first analysis of buyer-seller pairs. An equally important distinction is that we have multiple contracts for the same buyer or supplier firms, rather than a firm-average response, allowing for the correction of time-invariant firm characteristics that might determine the choice of credit terms. We find that the largest and most creditworthy buyers receive contracts with the longest maturities from smaller suppliers, and that discounts for early payment tend to be offered to riskier buyers.

Labor union pension funds have become increasingly vocal in governance matters; however, their motives are subject to fierce debate. I examine the proxy votes of AFL-CIO union funds around an exogenous change in the union representation of workers across firms. AFL-CIO affiliated shareholders become significantly less opposed to directors once the AFL-CIO labor organization no longer represents a firm's workers. Other institutional investors, including mutual funds and public pension funds, do not exhibit similar voting behavior. Union opposition is also associated with negative valuation effects. The data suggest that some investors pursue worker interests, rather than maximize shareholder value alone.

Because life annuities can increase the level and decrease the volatility of lifetime consumption, economists have long been puzzled by the low demand for life annuities. One potential rational explanation is that adverse selection drives up life annuity prices, which drives down demand. We study the choice between life annuities and lump sums made by 32,000 retiring public employees. These unique data allow us to extend the existing literature by exploiting economically significant cross-sectional and time-series variation in life annuity pricing. We find little evidence that retiree demand for life annuities rises when life annuity prices fall. We find strong evidence that demand responds to salient variation in individual characteristics, such as health, and to measures of investor sentiment, such as recent equity returns.

This paper offers a fully rational, dynamic model of opaque over-the-counter markets. An investor searches for an attractive price by visiting multiple dealers in any chosen sequence, including repeat contacts. The dealers do not observe negotiations elsewhere in the market, including the order of contacts. Under stated conditions, a repeat contact with a dealer reveals the investor's reduced outside options and worsens the price quote. When the fundamental value of an asset is uncertain, market opacity and uncertain contact order could exacerbate adverse selection and lead to inefficient market breakdown.

We use a natural experiment in Denmark to test the hypothesis that aspiring entrepreneurs face financial constraints because of low entrepreneurial quality. We identify 304 constrained entrepreneurs who start a business after receiving windfall wealth and examine the performance of these marginal entrepreneurs. We find that constrained entrepreneurs have significantly lower survival rates and lower profits when compared with a matched sample of unconstrained entrepreneurs. These results are consistent with the hypothesis that the marginal entrepreneur is of low quality.

We investigate the trade-off between incentive provision and inefficient rollover freezes for a firm financed with short-term debt. First, debt maturity that is too short-term is inefficient, even with incentive provision. The optimal maturity is an interior solution that avoids excessive rollover risk while providing sufficient incentives for the manager to avoid risk-shifting when the firm is in good health. Second, allowing the manager to risk-shift during a freeze actually increases creditor confidence. Debt policy should not prevent the manager from holding what may appear to be otherwise low-mean strategies that have option value during a freeze. Third, a limited but not perfectly reliable form of emergency financing during a freeze—a “bailout”—may improve the terms of the trade-off and increase total ex ante value by instilling confidence in the creditor markets. Our conclusions highlight the endogenous interaction between risk from the asset and liability sides of the balance sheet.